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The Lesson for Every Investor From Warren Buffett's Million-Dollar Bet

Warren Buffett made a 10-year, million-dollar bet on a low-cost index fund. There's a lesson there for every investor.

U.S. stocks are lower in early afternoon trading on Wednesday, with the S&P 500(SNPINDEX: ^GSPC) and the Dow Jones Industrial Average(DJINDICES: ^DJI) (DJINDICES: $INDU), down 0.08% and up 0.15%, respectively, at 12:50 p.m. ET. Meanwhile, the Nasdaq Composite Index (NASDAQ: ^IXIC), down 0.83%, is feeling the pain of lower iPhone sales.

Traders are waiting for the 2 p.m. statement from the Federal Reserve to start reading the tea leaves regarding the Fed's view of the economy and the likely future path of interest rates (spoiler: the main policy rate, the Fed funds rate, will remain unchanged today). Genuine investors can safely ignore this cartomancy.

From intraday returns to a 10-year bet on the S&P 500Berkshire Hathaway holds its Annual Meeting this coming Saturday. CEO Warren Buffett is known as a long-term investor, and he's also a fan of indexing (perhaps surprisingly, for someone whose fortune is the product of his ability to outperform stock indexes).

His confidence in the "do-nothing" strategy of indexing is such that, back at the outset of the global financial crisis, Buffett made a million-dollar bet with investment firm Protege Partners that an index fund could beat a portfolio of funds of hedge funds selected by Protege (the proceeds of the bet will be donated to charity).

The bet, recorded publicly here by the Long Bets Project (part of the Long Now Foundation), is as follows:

Over a 10-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds when performance is measured on a basis net of fees, costs, and expenses.

The detailed terms of the bet -- in particular, the funds of hedge funds selected by Protege -- have been kept confidential. However, at Berkshire's 2015 Annual Meeting, Buffett gave an update on the bet with a slide showing his S&P 500 index fund, the Vanguard 500 Index Fund Admiral Shares, trouncing Protege Partners' funds of hedge funds portfolio with a cumulative return of 63.5% versus 19.6%.

In February, Fortune's Carol Loomis reported that the funds of hedge funds managed to beat the index fund in 2015, but their margin of outperformance was barely significant, at 1.7% versus 1.36%. At the end of December, with just two years left to run, Buffett maintains a commanding lead:

Vanguard Index Fund Admiral Shares: 65.67%

Protege Partners' portfolio of funds of hedge funds: 21.87%

Even Ted Seides, the then-Protege Partners' partner, who initiated the bet, admitted last year that "[t]he odds now are that we'll need to see a severe market contraction for our side of the ledger to state an epic comeback. No one wins when that occurs."

That's a little more humility than he demonstrated at the outset of the bet, when he estimated his chances of winning at 85%; Buffett, less overconfident, thought his odds of success were 60%.

When he made the bet, Buffett argued:

[Active] investors will incur far greater costs [than passive investors]. So, on balance, their aggregate results after these costs will be worse than those of the passive investors. Costs skyrocket when large annual fees, large performance fees, and active trading costs are all added to the active investor's equation.

What is the lesson for individual investors who were never considering investing in hedge funds in the first place? All investors who are trying to beat the market are active investors -- not just hedge funds. That includes actively managed mutual funds, which many individual investors do invest in. Buffett's argument holds here, too: The simple truth is that the overwhelming majority of fund managers do not earn their fees.

That's a lesson every investor ought to have in mind: When you give your hard-earned money to a fund manager, you're making a bet, the odds of which are not in your favor.